Personal Guaranty: The Lowdown from a Chief Credit Officer

By Jeff Guldner

Often, small business owners will ask why lenders require them to sign a personal guaranty, especially when the lender also requires the business to pledge all or substantially all of its assets as collateral. The reasons are somewhat inter-twined, but the short answer is that it is a function of risk and the fact that most small businesses are also closely held and controlled.

As a rule, small businesses are riskier ventures than large businesses. In fact, the failure rate and default rate of a business increases as its size decreases. Said another way, size does matter. This is one reason why the lender will require a backup or secondary source of repayment in the form of a PG.

Another reason is that the small business is often closely held by one person, a family or several partners and is therefore simply an extension of the owner(s) and their lifestyle. The owner has absolute control of the business, being able to affect all decisions that impact the success or failure of the company, including strategic direction, policy making, management, capital structure, asset sales, liquidation and owner’s compensation. A PG is a show of confidence by the owner that the decisions being made are with an eye toward being sound financially and with the interests of creditors also in mind.

Finally, when a small business is no longer viable, the lender and other creditors are more likely to be repaid if the owner remains actively engaged in the orderly wind down or liquidation of the business. The owner can maximize asset sale or liquidation values as opposed to “throwing the keys to the bank.” The lending community often refers to this phenomenon as “aligning the interests of the owner with those of the lender.”

A logical follow up question is what needs to happen to negate the need for a PG in a small, closely held business. The short answer is that it probably won’t happen as long as the business remains small and closely held, given the reasons above. However, at some point lenders will not require a PG and factors influencing this decision are not only size and ownership structure but also the financial wherewithal of the company, collateral coverage, and depth and breadth of the management team. While not a true substitute for a PG, lenders may rely on financial and other covenants, as well as, asset based lending arrangements to control their lending risk. It is generally accepted in the marketplace that lenders will require PG’s on all closely held businesses and that getting a lender to move off this requirement becomes less likely the smaller and more closely held the company is.

To summarize, PG’s will be required from the controlling owner(s) in most all cases where you have a small, closely held business for the simple reasons that smaller businesses are generally riskier than larger ones and that the small business is considered an extension of the individual controlling it and therefore that person should be financially responsible for it. In the event the business suffers financial distress or fails, the continued involvement of the controlling owner in facilitating an orderly wind down or liquidation of the business generally results in a more favorable outcome for the creditors.

*A personal guarantee is an unconditional promise to pay, made by the individual owner, in the event of default or the inability to pay by the business.

Jeff Guldner has over 30 years of experience in credit risk assessment and management for major lending institutions. Guldner is the Chief Credit Officer for Ftrans. Ftrans combines accounts receivable management with affordable access to funding – providing small and medium-sized businesses the cash they need to take advantage of market opportunities and grow.